Jackson Hole truth telling: Monetary policy can't save the day alone

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Last week I noted that the IMF has lost any hope of monetary policy alone lifting Japan out of its deflationary torpor, but Japan is not the only country where monetary policy has disappointed.

The US recovery has been uncharacteristically lethargic, despite adventurous monetary policy initiatives. European unemployment is still in double-digits, with Italian GDP 8% lower than in 2007. A panel of experts looked at this issue recently at the Lowy Institute; for their take, listen here.

If the recovery from the 1930s Great Depression is anything to go by, deep recessions are followed by strong recoveries as the economy takes up the slack and gets back to potential output: US GDP grew by 8% in each of the three years to 1937. That certainly didn’t happen after the 2008 Great Recession. The recovery was neither rapid nor is there any prospect of getting back to the old trend line. The first chart below shows US actual GDP growth and successive forecasts of potential growth, each one more pessimistic than the last.

This chart shows the same thing for Europe.

Monetary policy responded promptly and strongly to the crisis. By the end of 2008, the US policy interest rate was close to zero and others were not far behind (although the European Central Bank (ECB) was tardy). But not much happened. Output growth was consistently below forecasts and inflation remained below target.

The response was to increase the dosage. With the policy rate already effectively at zero, central banks in crisis-affected economies searched for other ways to apply stimulus. Some of this was fairly conventional, at least in the context of a financial crisis. Where financial markets had become dysfunctional because of investor funk, central banks bought assets to restore liquidity in these markets. They also supplied liquidity to banks, including foreign exchange liquidity via swaps with the US Fed. They provided ‘forward guidance’ to assure markets that policy would remain accommodative. The Bank of Japan (BoJ), the ECB and a couple of smaller European central banks set their policy rate at a small negative level.

As well, all four major central banks (the US Fed, the Bank of England, the ECB and the BoJ) began large-scale bond purchases, with the same motivation: with policy rates at zero, they wanted to apply more stimulus. These massive ‘quantitative easing’ (QE) operations were breaking new ground, flooding financial markets with central bank money (‘base money’), buying up 25%-30% of the outstanding stock of government debt. Japan had tried QE operations earlier without much effect, but these massive operations undoubtedly flattened the yield curve. Just how much this stimulated output is debated, but it certainly boosted share prices and depreciated exchange rates, both supportive of domestic growth. Inflation, however, remained stubbornly below target and the recovery remained limp.

Some believe that monetary policy did as well as could be expected. After all, every economics student knows that monetary policy is not very effective in stimulating an economy; ‘like pushing on a string’, or so they say. The crisis environment didn’t help. The epicentre of the 2008 crisis was the financial sector, which is always slow to recover, dampening financial intermediation. Both banks and over-leveraged borrowers have to restructure their balance sheets, and prudential regulators (having been caught out in 2007) imposed more capital and regulatory requirements on the banks (and hefty fines for banks’ earlier transgressions). As a result, the financial system (though awash with base money) didn’t expand credit.

On top of this, fiscal policy was tightened in the aftermath of the 2008 crisis. After just one burst of fiscal stimulus in 2009, budgets were reined in because of debt fears (some would call it debt-phobia). America, for example, reduced its budget deficit by an amount equal to 5% of GDP. Assuming a budget multiplier of one, this fiscal consolidation took 5% off growth, spread out over a four year period. Austerity in Europe was probably harsher, and Europe also had to cope with the 2010 collapse of the peripheral economies, starting with Greece.

What lessons should monetary policy-makers take from this experience? There is nothing approaching consensus here, but here’s my take.

The mistakes of the 2000s were many: overly-low interest rates, irresponsible lending to NINJAs, ineffective prudential supervision, over-leveraged banks relying on flighty funding, and credit rating agencies prepared to hand out AAA ratings on demand. All this came home to roost in 2007-08.

The balance-sheet repair needed when the bubble burst was profound. To impose budget austerity after just one small shot of fiscal stimulus in 2009 was a very serious policy error. Strong recoveries (not just 1935-37, but the US recovery after the Volcker shock of 1979) require fiscal stimulus to boost demand. Without this, low interest rates have limited stimulatory effect; new investment needs the clear prospect of stronger demand, as well as cheaper funding. The ‘pushing on a string’ analogy is unhelpful: accommodative monetary policy is a prerequisite for recovery. But it doesn’t get effective traction without fiscal support as well. The unconventional monetary policy measures (QE, negative interest rates, and forward policy guidance) are measures of desperation, with modest impact.

When policy interest rates were lowered to zero, central banks (Ben Bernanke in particular) should have said that the monetary instrument was working strongly, but was ‘pedal to the metal’. To be effective in the face of strong headwinds, this monetary stimulus needed to work in tandem with fiscal policy to give the recovery a strong kick-start. Instead, ‘Helicopter Ben’ assured everyone that things were under control: he had more instruments in his policy kit. He let those in charge of fiscal policy off the hook, to make their usual lame excuses for inaction: debt phobia; Ricardian Equivalence; and ‘confidence fairy’ effects.

In due course the balance sheet repair will be finished. Some businesses will start looking for expansion opportunities. The low interest rates will encourage them to start borrowing again. This is already happening in America. But the new growth trajectory will be far below what seemed feasible in 2007, with economies suffering permanent damage from the long period of labour underutilisation.

The extensive use of unconventional policies has undermined the beautiful simplicity of inflation targeting. The core tenet of central banking (that governments cannot command the central bank to fund budget expenditure) has been eroded by QE and would be entirely undone by ‘helicopter money’. Unsurprisingly, the Jackson Hole symposium pondered more radical changes to monetary policy to try to restore its effectiveness; economists are never short of sure-fire panaceas. The Economist joined the clamour, with a confused editorial advocating nominal income targeting as the new ‘silver bullet’.

Few central bankers will acknowledge the asymmetric nature of their power. They are able to stop an inflationary burst, albeit painfully (the 1979 ‘Volcker deflation’ in America, or the 1990 ‘recession we had to have’ in Australia). With competence and some luck, central banks may be able to maintain inflation close to target in good times. But when the economy falls into a deep hole, monetary policy shouldn’t be expected to carry out the rescue alone.